A futures contract is an agreement between a buyer and seller of an underlying asset: a commodity, like barrels of oil, or a financial instrument, like U.S. treasury bonds. At the time that the contract is established, the participants lock in the futures price, which is the price that will be paid on the delivery date. The delivery dates, which are standardized and occur monthly, can range from one month to many years into the future. The value of a futures contract at any given moment is the current futures price of one unit of the underlying asset times the number of units in the contract.
Purpose of the Futures Price
The futures price, which is the delivery price, is established in a contract agreement and locks in the price of an asset that will be delivered at a later date. No matter what happens to the asset’s price over the life of the contract, the delivery price is fixed. This is useful for participants such as wheat growers, who may enter into a contract early in the growing season. They sell one or more contracts to deliver a set amount of wheat at a delivery date around harvest time. The buyer of the contract may be a wheat processor. Both parties want the financial clarity that a guaranteed price provides. This use of a futures contract to prevent an unwanted loss on the underlying asset is called hedging. Speculators also trade futures, seeking to profit from changes in a commodity price without any intention of actually accepting or delivering the underlying asset -- they use cash-settled contracts or close out physical-delivery contracts before the expiration date.
The value of a futures contract is constantly changing to reflect the price of the underlying asset. Futures contracts are highly standardized and trade on a futures exchange. Among the standards are the quantity and quality of asset to be exchanged and the date and place of delivery. For instance, an oil futures contract will specify a particular type of oil, such as light sweet crude, and a number of barrels, say 1,000. The contract value at any one time is the futures price at that time for one unit -- a barrel of oil -- multiplied by the number of units in the contract -- in this case 1,000. Futures prices arise from an ongoing open-outcry auction on a futures exchange floor where traders place bids and asks around a trading pit. In some places, this scheme has been replaced by computerized trading.
Futures Price Versus Spot Price
Notice that the current contract value depends on the current futures price. This may sound confusing, but it’s actually straightforward. The current futures price is the delivery price participants would agree to if they established the same contract today. It is the best estimate of what the spot price of the commodity will be on the contract expiration date. The spot price is the price for immediate delivery. At any given time, the current futures price lies within the current bid/ask spread for the exact same type of contract and is constantly changing due to changes in the spot price, expectations of supply and demand, current money market rates, time left until delivery, price volatility and other factors. All of these factors guide the auction activity on the exchange floor, where the latest futures price is established.
All futures contracts have an expiration date, which occurs a week or two before the delivery date, depending on the standard specifications of the contract. The determination of a futures contract value works differently on the expiration date. On that date, the spot price is used instead of the current futures price to calculate the contract value. This forces the current futures price to converge toward the asset spot price as the expiration date approaches. During the life of the contract, money is transferred between the traders at the close of every trading day to reflect the change in the contract value: the buyer receives a payment if the current futures price increased since the previous day, and the seller gets paid if the price declines. On expiration day, the final transfer occurs, based on the spot price at end of the expiration day versus the futures price at the close of the previous trading day.
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